Superleverage

We all know how risky and intimidating the markets can be…That’s why Steve Sarnoff shares with us a sort of “trading survival guide”: the important factors to successful speculation.

When people find out that I write a financial newsletter, they invariably ask, “What should I do with my money?”

Here’s my polite answer: “The best advice I can give is…make money, don’t lose it!”

Let’s clear something up: My work is not about investment.

Successful investing is like planting acorns and watching them turn into oak trees. I don’t work that way. My specialty is speculation, where the real money is made.

Speculation is more like playing with fireworks on a rainy winter’s evening. You light the fuse, and seconds later, it’s either fizzled out or a huge colorful explosion high up in the sky has illuminated the whole world.

Even though I’m a mild-mannered vegetarian pacifist, with over 20 years spent living in southern California, you won’t find many traders more aggressive than me. When I see the odds in my favor, I jump in with both feet. If I’m wrong, I accept my loss and get out. If I’m right, I don’t get complacent; I take my profits and I run.

Aggressive Trading: The Complete Game Plan

Planning is the key to an aggressive trading style like mine. I operate under what I call: The Complete Game Plan for Trading Success.

For each trade, you should consider what action you will take if you are right (where to take profits and how much of your position to exit) and what you’ll do if wrong (use stop-loss strategies or hold on and risk a worthless expiration).

My dad, Paul Sarnoff, explained it best, “Every trader with imagination and talent goes into a specific commodity armed with a trading plan,” he wrote. “Simply put, the trading plan involves the following factors:

1.Preset entry points – a price level at which the trader will enter the market.
2.Preset exit points, where the trader will realize profits.
3.Stop-loss points, where the trader will absorb his losses and limit his exposure in adverse markets.

The astute trader will have a plan for the useful employment of monies and equity generated if the market is favorable and a plan for averaging prices down by adding contracts if the markets retreat temporarily.”

The only certainty in markets is that they’ll fluctuate. Speculators make their fortunes from those changing prices. In the business, it’s called volatility.

Leverage is an important tool for speculators. In fact, leverage is the magic that turns small price movements into large profits…or losses. It is found in many different guises, but the fundamental design is always the same. The leveraged speculator uses OPM (Other People’s Money) in an attempt to make more money than would otherwise be possible with nothing but his own funds. In other words, you augment your position with borrowed money.

It sounds dangerous…and if not managed prudently, it can be bad for your wealth. BUT, if leverage can be applied to situations with strictly limited risk, it takes on a more sensible aspect. It becomes…

… superleverage.

Aggressive Trading: The Instruments of Superleverage

Superleverage is the art of profiting from changing prices, with limited risk. No margin calls, no demands for additional funds, no forced liquidations.

The instruments of superleverage are exchange traded put and call options.

Limiting your trading to the purchase of puts or calls may be the simplest options strategy, but it’s also the most effective. While more complex “spread” strategies can further limit your risk, they also limit your gain…and generate greater commissions and fees with your broker.

The advantages of using superleverage are: You don’t need to be a financial wizard or have large sums of money to participate. Secondly, you get all the benefits of OPM when you are right, but unlike futures and other leveraged instruments, your liability is capped.

The disadvantages are: The odds are against you. Options are wasting assets. And if the underlying security doesn’t move enough to give you real value, before a specified date, your options will expire worthless. That is your risk.

It was once calculated that 90% of all options expire worthless. That doesn’t mean you have a 90% chance of losing money…a winning options trader will offset one or two spectacular winners against eight or nine losers…and still have money left over.

When I’m wrong, my subscribers can lose 100% of their speculation, but not one cent more. And that’s the important part, because when I’m right, they have an opportunity to multiply their money many times over.

But there’s no easy money in this game and regularly reaping hard-earned rewards is a worthy challenge.

That’s why my father created Options Hotline 16 years ago. I was fortunate to work as his associate editor for four years, before he passed away in October of 1999. He taught me everything he knew about the markets. Now, in my sixth year at the helm, I know he would be proud of how the service has grown and consistently helped so many fine folks beat the odds.

Speculation: The Three Cornerstones of Success

But many speculators fail…even when armed with good picks. I think it was Woody Allen who said, “In life, there are pitfalls and there are opportunities. The idea is to avoid the pitfalls, seize the opportunities, and get back home by six o’clock.”

Here are my brief thoughts on how you can do just that:

We already talked about the importance of a complete game plan. The three cornerstones of your plan should be: psychology, method, and money management.

Psychology is to the trader as fitness to the athlete. You must be of sound mental fitness to speculate successfully. There are two aspects to this or, as we call them in the business, the “Twin Tolerances for Risk.”

Financial tolerance is easier to determine. Do the math…annual income, liquid net worth, etc. You should only speculate with risk capital (money you can afford to lose).

Psychological tolerance requires you to be able to sleep at night and not let rollercoaster markets adversely affect your family life. You must look deep inside yourself to determine if you have the nerve and can handle the pressure of speculation. If a bad trade knocks your confidence, reassess your strategy, don’t just double up your position and hope to win it back…like most people do.

Method is how you make informed market decisions. You must either do your own research, or pay for it. This is what market advisory services, such as Options Hotline, aim at.

The most important factor in successful speculation is sound money management. Trading success is more a function of honing your survival skills than picking winners. Most people have it backwards. They speculate based on hyped up hopes of fantastic profits. You should speculate based on what you can lose, not what you can gain. Be prepared to handle trading losses. Never add to a losing position. That is how many players get knocked out of the game. You want to be in there when the market goes your way. You, or your broker, must monitor your positions closely. They don’t ring a bell when it’s time to get out, so make sure you have an exit strategy in place for each trade.

Okay, now that I’ve bored you to death with my trading strategies, you probably want to know what I see happening now.

The Dow closed yesterday’s session (Wednesday, 01/26/05) at 10,498.59. I see underlying technical support at the following levels: 10,380-10,450, 9,950-10,150, and 9,660-9,750. The venerable index looks like it wants to test support in the low-10k area, and could do it within the next week of trading. That would be a good potential short-term turning area.

My contrarian senses are tingling. Over the longer-term, I think the surprises of the year will be turn out to be: strength in the U.S. dollar, rising long-term rates, and falling Apple shares.

The iPod people’s shares are trading around $70. I know they’re wonderful and selling like crazy, but that’s not what I base my decisions on. I study price movement to determine who is stronger (buyers or sellers) and when that balance of power is likely to shift. Sure, everyone loves them; but the character of the behavior of share price movement tells me sellers are poised to gain the advantage for the first time since July. From Apple’s current level, resistance is at $71.76-$74.42 and support is at: $68.25, $63, and $45-$50.

Oil has support around $40 and gold is trying to hold support around $420. If the dollar rises, gold will face pressure and may need to shake out more of the weaker longs before resuming its rise.

Above all, have fun…if you ever get bored, or tired of speculating, you are toast, and the markets will eat you for breakfast.

This is the most important advice I could give you.

Regards,

Steve Sarnoff
For the Daily Reckoning

January 27, 2005 — London, England

P.S. The most valuable thing you can spend is your time. Much of the financial commentary I see and hear is distracting noise, lacking truly useful information. In writing the Options Hotline, I always keep that in mind and strive to provide my clients only with the valuable information they need to vie for fun and profit in today’s markets. It’s strictly a no-fluff zone.

Since January 4, 2004, of the 34 recommendations Steve Sarnoff made, 30 of them were winners. Not only that, 11 of them doubled in value! Using Options Hotline, Mr. Sarnoff has surpassed a million dollars in gains…and to celebrate, we’re offering this service for one year at $250 dollars off the regular cost.

It is the World Cup, the World Series and the Olympics all in one. The world’s top players are all in Davos, Switzerland. The press. The celebrities. The movers and shakers.

The sport is humbug…and the stakes are huge.

Attendees are all committed to “improving the state of the world.” There are heads of state, such as Tony Blair and Gerhard Shroder. There are heads of business, such as Bill Gates and Michael Dell. There are the various has-beens and wannabes appearing in the press from time to time: Bill Clinton, Lord Carey, Mahmoud Abbas, and so forth. And there are the idealists, the bleeding hearts, and various no-talents on the make, such as Angelina Jolie and Sharon Stone. Judging from her performance in Alexander the Great, Angelina could easily improve the world; all she needs to do is to take acting lessons, or retire from the silver screen.

But as we know, the world improvers are never really interested in private acts of self-improvement. Instead, they favor great public spectacles that flatter their vanity and generally lead to disaster.

The only major league world improvers who are not attending this year’s World Economic Forum are the members of the Bush Administration, who have so many world improvements already in progress they need no further inspiration.

Yesterday, Tony Blair warned the world to get serious about climate change. Jacques Chirac, even more compassionate than Mr. Blair, proposed a tax on air traffic and capital flows into countries that refuse to force banks to blab the details of their customers’ wealth.

“It’s an honor to be here among all you smarty pants,” said Sharon Stone. We don’t know why she thought they were all such smarty-pants. Looking down the list of attendees, what we see are mostly sinners and hacks…with a few delusional artists in the mix.

Conspicuous by his absence is your very own editor, whose invitation to Davos must have gotten lost in the mail. But we are grateful to Fred Bergsten of the Institute for International Economics in Washington; Fan Gang, the director of the National Economic Research Institute in Beijing; and Stephen Roach of Morgan Stanley, for taking his message to Davos.

The “weakest link” in the world economic picture, Mr. Roach told attendees, is the “‘self-indulgent consumer” in the United States, who depends on a “bubble” in real estate prices in order to continue living beyond his means. Yesterday, the consumer, along with a spendthrift government, brought news of a record budget deficit of $427 billion this year, which poses a grave threat to the world economy. If these excesses are not addressed, warned Mr. Bergsten, “the dollar would come down sharply, U.S. inflation and interest rates would be pushed up sharply and the world would follow a much slower growth pattern. Trade would be a big casualty: it would be poison for U.S. trade policy.”

Meanwhile, Fan Gang revealed that his government had lost faith in the dollar. “The U.S. dollar is no longer (seen) as a stable currency,” he said. In the months ahead, China would begin to separate itself from the dollar that ‘will not stop devaluating,’ he told the world improvers. As to why China hadn’t done so already, he explained that it was a bit like fixing a roof. When it rained heavily (such as last fall when the dollar was falling sharply) you can’t do it…and when the sun is shining, you don’t have much interest in doing it: “High pressure…we don’t do it. When pressure’s gone, we forgot.”

This time, we won’t forget, Fan vowed. The Chinese are said to be buying euros.

More news, from our team at The Rude Awakening:

————–

Eric Fry, reporting from New York City…

“Because dollars are plentiful and crude oil is scarce, large holders of the former have become increasingly interested in exchanging them for the latter.”
————–

Bill Bonner, back in London:

*** Next week, G7 will gather in London…

The chin-wagging has already started. You know what Fan Gang told the crowd in Davos yesterday, next we hear Mr. Jin Renqing, China’s Finance Minister, is heading to the G7 meeting with the specific intention of engaging world leaders in “a deep dialogue” on China’s exchange rate.

Is an end of the dollar’s peg in sight?

Hardly says trading wizard Dennis Gartman. “We thought [the statement was] important. However, we thought it less important than did, or has, the rest of the foreign exchange dealing world. To the rest of the world this was a virtual tectonic plate shift. To us it was notable…interesting…. even perhaps important. But earth shattering? Hardly.”

“We must always remember that when dealing with things Chinese, rhetoric is perhaps more important than anywhere else in the world. Subtlety… even obscurity…. is a virtual art form amongst the international foreign relations and economic cognoscenti, and it is especially so at the highest levels of China.”

*** Gold rose to $426 yesterday. We ratchet up our target-buying price once again. This time, we buy below $425…and hope the price falls again so we can buy more.

*** Two fat kids are suing McDonald’s…again. The suit was thrown out once…but it’s back. Surely, the kids are world improvers. They think the world would be a better place if McDonald’s had to print “HAMBURGERS KILL” on their Big Mac boxes…and the kids had $100 million in their bank account.

*** Another reader; with another interpretation of God’s holy writ:

“Regarding the January 20th issue, in which a reader reproaches a previous contributing reader with his understanding of the meaning of ‘Thou shalt not kill,’ I would like to add my two bits worth to the linguistic part of the debate.

“The words translated as, ‘Thou shalt not kill’ are the Biblical Hebrew ‘Lo tirtzach.’ It is clearly not Aramaic, as your reproachful second reader wrongly states. The fest of the two words is not ‘Laa’ but ‘Lo,’ even though it is written with an aleph, so your reproachful second reader is wrong here too.

“More importantly, he is also wrong, along with the King James Version, about the translation of the expression, which clearly means, “You shall not murder,” as the previous reader correctly asserted in the first place. If anything, you may even want to make it: ‘You shall not assassinate,’ to render the element of criminal, unlawful premeditation contained in the Hebrew word. For whatever good or bad theological or English reasons of his own, the translator who came up with the King James chose to make it ‘You shall not kill’ (in the English of his days, which actually has nothing inherently Biblical about it) but this is very clearly not what the original Hebrew means.

“Your reproachful second reader might want to get his facts straight, language-wise, before he uses wrong arguments to hurl insults at the previous reader, who was language-wise absolutely correct. The accumulation of errors made by your reproachful second reader actually makes him look rather ridiculous and weakens his political case considerably.

“I hope that this does not spoil your nice day.”

*** This week marks the 60th anniversary of the liberation of Auschwitz. There, the Nazis put millions of people to death. The victims were surely killed. But were they “murdered” or “assassinated?” We pause to admire the suppleness of the language and the human brain. Can a legitimate government – especially one of the world’s most advanced and supposedly civilized nations – “murder” someone? Is it murder when a government hangs a criminal? Is it murder when the government bombs a city of a nation that never attacked it and with which it is not at war? What if the killing is part of a government program intended to improve the world?

We don’t know.

For our own part, we will take the King James Version the way we learned it as a child. If we are going to kill someone, we will need a damned good reason. And even then…may we roast in Hell if we did the wrong thing.